How Does a Retirement Annuity Work?

An annuity is an agreement between an individual and an insurance company that results in the individual receiving income over a period of time or over a lifetime in exchange for the individual's cash, either in a lump sum payment now or a series of payments over time. The income from the insurance company can start at any time. If it starts sometime in the future, then it is a deferred annuity. If it starts as soon as the contract is signed, it is an immediate annuity. To receive an immediate annuity, the individual has to hand over a lump sum of cash now.

A retirement annuity is a deferred annuity purchased as part of a retirement plan or within an Individual Retirement Account (IRA), in which you receive your income from the insurance company during retirement. Any growth that takes place in the annuity is both tax deferred (you start paying taxes when you receive income) and tax deductible (because it is within an IRA).

How They Work

There are basically three types of tax deferred annuities: fixed, variable and equity-indexed. Fixed annuities give you a guaranteed monthly income during the payout phase based on a guaranteed rate of return agreed upon when you signed up. This income is of course affected by inflation. For an extra fee your income can be adjusted for inflation by increasing it by a few percentage points each year.

A variable annuity has a variable rate of return and you are allowed to invest your money in a few funds that look like mutual funds but are not the actual funds. They are called sub-accounts and mirror the performance of the actual mutual funds but the management fees are higher, in effect reducing your returns.

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Equity-indexed annuities are tied to an index fund and you are allowed to invest money in the annuity in one or more of the index funds in the stock market. This means that you are able to take advantage of growth in the stock market but only to some extent because most annuities do not have a 100 percent participation rate. Therefore you only truly realize a percentage of the growth of that particular index.

Pros and Cons of Annuities

Most people who choose annuities as a retirement option are attracted by the guaranteed rate of return and guaranteed fixed income they provide. Many are also sold on the tax deferred properties of annuities. It is not surprising then that many people see their appeal, especially those that are retired or very close to retirement. However annuities are not without their downsides, the main being mediocre returns and missing out on growth in the stock market especially over the long term.

Another disadvantage of annuities is that their being tax deferred is not always as beneficial as it is made out to be. The chief reason for this is that even though an annuity can grow tax deferred, when you start receiving distributions you will pay income tax at the prevailing rate on the earnings, not capital gains tax. After paying all the fees associated with owning an annuity, you end up making less than you would have if you put your money in a regular taxable investment account with the same rate of return, because you'll only pay capital gains tax.